Preferred Stock vs Convertible Notes

The formulas, tricks and trade secrets of Private Equity

Preferred Stock vs Convertible Notes

I hope I’ve mentioned it before… private equity is firstly about risk mitigation and secondly about earnings growth. This is why private equity firms rarely invest cash as ordinary equity; they want the extra protection that comes with preference equity. One of the most common points of contention though, is the use of coupons on preference equity (or interest payments on convertible notes). Vendors often feel that private equity firms shouldn’t get the benefits of a debt while enjoying the upside of equity.

Preference coupon payments mitigate risk by returning cash to the private equity investor sooner. The returned money can’t be lost and it is worth more than money returned at exit (time value of money). But, this is hardly consolation for the vendor who is stuck with ordinary equity and no guaranteed periodic payments.

Preferred Stock

By saying what I’m about to say, I’m probably going to feel the full wrath and scorn of the private equity industry, but c’est la vie. I believe a coupon is only fair if:

it is intended to offset an abnormally high top-line valuation; and/or

there is a mechanism in place to compensate management on the upside.

An example scenario is if the private equity firm values the business at $X, but the vendor wants to set a precedent for future investments at $X+Y. The private equity firm could agree to the $X+Y valuation by offsetting the uptick by a preference coupon payment.

Convertible Notes

You may note that I’m being a little hypocritical. In a recent post, I lauded the strategic value of the private equity offering and suggested it was worth more than any upfront valuation by a trade buyer. However, there needs to be balance. Those of you too aggressive with coupons should probably weigh the value of these coupons against the opportunity cost of lost deals. You can try to justify your coupons a million different ways, but at the end of the day, if it doesn’t feel right for management, then the deal won’t proceed.

When you invest in a company, you have a chance to dictate your desired risk/reward profile. If you’re highly risk averse and you believe the company is solid, you can simply provide a loan with interest. At the other end of the spectrum is ordinary equity (or call options, if you’re so inclined), which give you access to the investment’s upside, but provide little in the way of capital protection.

Preferred Stock helps an investor find a middle ground. It gives access to upside, but it also protects (somewhat) on the downside by subordinating common stock (or ordinary equity). But there’s more. Preferred stock can also have a coupon, just like an interest rate, which returns the investor’s capital over time. So even if the company fails, the interim coupon payments mean the investor doesn’t lose everything. If the company does well, the investor also gets access to the upside.

Preferred stock can either be accumulative or noncumulative. A accumulative adopted requires that if a aggregation fails to pay any allotment or any bulk beneath the declared rate, it accept to accomplish up for it at a afterwards time. Assets accrue with anniversary allotment period, which can be quarterly, semi-annually, or annually.

Prior preferred stock

Preferred Stock vs Convertible Notes

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